How California Can Avoid a Sequel of the Budget Crisis

At long last Gov. Arnold Schwarzenegger has signed the budget, but Californians may want to hold off on any celebration. The blockbuster $84.6 billion deal is packed with accounting tricks that virtually guarantee a sequel of the crisis. A long-term solution could be at hand, but only if legislators come to terms with the cause of California’s fiscal instability.

The new budget does not raise taxes, a wise move because California’s top income tax rate is already 10.55 percent, fourth highest in the country. Legislators reluctantly turned to cuts totaling $16 billion, including $6 billion to K-14 education and $3 billion to the University of California. Legislators also indulged their familiar shell game.

They bumped back the last payroll of the year from June 30 to July 1, the start of the next fiscal year. This saves $1.2 billion from the current year’s budget, but the “saving” is spurious, as it literally pushes back the problem by a single day. The state has also cracked down on collection, forcing taxpayers, in effect, to give the state an interest-free loan. As it happens, California’s complex and punitive income tax code is the root cause of the budget crisis.

The code deploys a full seven tax brackets, tightly compressed, and a dizzying array of loopholes. A mere 144,000 of the wealthiest Californians, out of a population of 38 million, pay half of the income taxes. Assembly Speaker Karen Bass, a liberal Democrat, calls this “a crazy statistic,” with good reason.

During good years, California’s current arrangement bumps many taxpayers into higher brackets, where they pay higher rates on their large incomes. During recessions, many taxpayers earn less and also pay a lower rate on their incomes. This one-two punch devastates tax receipts. The California tax code thus exaggerates the natural ups and downs of the business cycle, and leads legislators to dig themselves into a fiscal hole.

When in a hole, one should stop digging, but legislators like to kick the problem down the road. The severity of the crisis, however, with an unemployment rate of 11.6 percent and a million Californians of all income levels fleeing the state over the last five years, has forced some legislators to recognize the need for tax reform.

In late 2008, Governor Arnold Schwarzenegger created the bipartisan 14-member (12 at the outset) Commission on the Twenty-First Century Economy, tasked “to re-examine and modernize California’s out-of-date revenue laws that contribute to our feast-or-famine state budget cycles.”

I testified to this commission about the benefits of a flat income tax, based on my 2008 study Ending the Revenue Rollercoaster. I estimated that California could scrap its complicated income tax code, along with the estate and gift taxes as well as the alternative minimum tax and taxes on corporate dividend payments, and replace them with a simple, flat-rate income tax of 3 percent.

A Californian making $50,000 would pay the same flat rate as a Californian making $500,000. The 3 percent flat tax would yield the state at least the same revenues, on average, as the present system. The crucial difference is that the revenue would be more evenly distributed between good and bad years.

The Commission on the Twenty-First Century Economy is expected to recommend a flatter personal income tax code — meaning fewer brackets and loopholes, and lower rates on the top brackets — if not an outright flat tax. The commission just had its deadline pushed back, and is now expected to issue its final recommendation by September 20.

Whatever the commission recommends, Assembly Speaker Bass says, she will put to an up-or-down vote before the state legislature. This could be a golden opportunity for reform in the Golden State, which the current gimmick-ridden budget will not achieve.

If legislators want a long-term solution to California’s recurring budget crises, they must dampen the boom-bust cycle in the state’s revenue stream. Flat-tax reform is a crucial first step toward the stability and economic growth California needs.